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Cogent Communications Group, Inc. (NASDAQ:CCOI)

Q1 2008 Earnings Call Transcript

May 9, 2008 8:30 am ET

Executives

Dave Schaeffer – Chairman and Chief Executive Officer

Tad Weed – Chief Financial Officer

Analysts

Jonathan Schildkraut – Jefferies & Co.

Frank Louthan – Raymond James

Tim Horan – Oppenheimer

Erin Schmitz – Citigroup

Jurgan Usman – Wachovia Securities

Nick Netchvolodoff – Lehman Brothers

Tom Watts – Cowen and Company

Andrew Bill – [Arete] Research

David Dixon – Friedman, Billings, Ramsey

Operator

Welcome to the Cogent Communications Group first quarter 2008 earnings conference call. (Operator Instructions) I would now like to turn the conference over to Dave Schaeffer, Chair and Chief Executive Officer of Cogent Communications.

Dave Schaeffer

Welcome to our first quarter 2008 earnings conference call. I’m Dave Schaeffer, Cogent’s Chief Executive Officer. With me on today’s call is Tad Weed, our Chief Financial Officer. We’re pleased with our results for the quarter, our first quarter revenue, EBITDA and loss per share either met or exceeded our first quarter guidance provided to you on our last call.

During the quarter as part of our second $50 million stock buyback program, we returned a total of $18 million to our shareholders by purchasing 981,000 shares at an average price of $18.40 per share. As of today, approximately $20 million remains available under this second $50 million authorization.

Through yesterday, under our total of $100 million stock authorization program we have purchased a total of 3.3 million shares of our common stock for an aggregate total cost of approximately $80 million. During the quarter we continued to expand our EBITDA and gross margins, demonstrating the tremendous operating leverage of our on-net business.

For Q1 2008 our gross margin expanded by 270 basis points to 57.9% and our EBITDA margin expanded by 140 basis points to 28.1%. Our direct incremental on net gross margins continued to be approximately 100% with direct incremental on-net EBITDA margins of approximately 95%.

During the quarter we continued to increase our footprint. We added 30 buildings to our network. We added over 4,000 intercity fiber route miles and over 900 miles of metro fiber to our network during the quarter. I want to personally thank the entire Cogent team for their efforts in helping us achieve these results.

Throughout this discussion, as in the past, we will continue to focus our results and focus on the impact of our on-net business which today is approximately 82% of our total revenues. We continue to highlight several operational statistics that we believe will demonstrate our increasing gain in market share, expanding scale, and operating leverage of our on-net business.

I will review certain operational highlights and also outline our continued expansion plans and growth opportunities. Tad will provide some additional details to our financial performance. Tad will also walk through our guidance for the second quarter of 2008 and update and reaffirm our guidance for full year 2008. Following these prepared remarks, we will open the floor for questions and answers. Now I’d like Tad to read our Save Harbor language.

Thaddeus Weed

This first quarter 2008 earnings report and this earnings conference call to discuss Cogent’s business outlook can contain forward-looking statements within the meaning of section 27A and section 21E of the Securities Act.

Forward-looking statements are based upon our current intent, belief and expectations. These forward-looking statements and all other statements that may be made on this call that are not historical facts are subject to a number of risks and uncertainties and actual results may differ materially.

Please refer to our SEC filings for more information on the factors that could cause actual results to differ. You should also be aware that Cogent’s expectations do not reflect the potential impact of mergers, acquisitions, other business combinations or financing transactions that may be completed after today. Cogent undertakes no obligation to release publicly any revisions to any forward-looking statement made today or otherwise update our supplement statements made on this call.

Also during the call, if we use any non-GAAP financial measures as defined by the SEC and Reg G, you will find these reconciled to GAAP measurements in our earnings release and on our website at cogentco.com. Now I’d like to turn the call to Dave.

Dave Schaeffer

Hopefully you’ve had a chance to review our earnings press release. As within previous quarters, our press release includes a number of historical quarterly metrics. These metrics will be added to our website. Hopefully you find these metrics informative and helpful in understanding our financial results and the trending in our operations. As always, if you have any suggestions for us to add or refine or perhaps even delete some metrics, please let us know.

Our first quarter 2008 revenue of $52.1 million was consistent with our guidance for total revenue of greater than $52 million. EBITDA as adjusted of $14.6 million was consistent with our guidance for the quarter of having EBITDA greater than $14.5 million. Our loss per share of $0.21 was within our guidance range of $0.17 to $0.22 per share.

As Tad will explain, a non-cash asset impairment charge reduced EPS in the first quarter of 2008 by more than $0.03. As a result, our recurring loss per share was in fact $0.17. We continue to be pleased with the growth of our on-net business which continues to grow at a rate greater than that of our competitors. However, we did not meet our targeted FTE representative productivity goals for the quarter and have taken a number of measures to proactively improve their performance.

These measures include adding retention bonuses for our representatives who continue to achieve quota in six month increments, adding additional sales support staff, adding an enhancing our training program for our sales reps and finally adjusting our compensation program to ensure that reps are only compensated for gross margin, therefore incenting our entire sales force to focus on our on-net products.

During the quarter we again extended our average contract length by approximately 3% as many more customers continue to enter into long-term contracts and customers continued to express their increased confidence in Cogent and Cogent’s value proposition.

Now I’d like to talk in a little more detail about some of our revenue and traffic trends for the quarter. Total revenue for Q1 2008 was $52.1 million. This represented a 4.3% increase over fourth quarter 2007 and a 19.5% increase over Q1 2007. Traffic on our network continues to grow and traffic growth for the quarter was approximately 7%.

On-net revenue and on-net revenue derived from our customer connections also continues to increase. On-net revenue increased by 5.7% sequentially, Q1 2008 from Q4 2007. This growth rate was less than the increase of 7.6% that we had experienced in the third quarter 2007 to fourth quarter 2007.

Our on-net customer connections increased at 5.9% sequentially, Q1 2008 over Q4 2007. On-net revenue continues to increase as a percentage of total revenue, growing from 81.1% of total service revenue in Q4 2007 to 82.2% of total revenues in first quarter. Approximately 90% of our new sales in Q1 2007 were from our on-net services. Revenues from our off-net services also increased approximately 0.3% for the quarter and non-core revenues actually declined 12.2% for the quarter.

Now I’d like to spend a moment talking about ARPU and pricing trends. Cogent remains committed to being the industry price leader. Our pricing for our mostly widely sold product remained at $1,000.00 a month for 100-megabit connection or $10.00 per megabit.

We continue to offer discounts for longer-term contracts. We also continue our policy of undercutting our competitors. While we did see a slight increase in the number of competitive offers in which our customers availed themselves of these further discounts, it was still only about a dozen incremental orders out of our total sales funnel.

We continue also to guarantee a provisioning cycle of 17 business days or less for our on-net services. In the first quarter we delivered in excess of this guarantee, in fact provisioning our on-net services in an average of ten days. Our on-net ARPU was essentially unchanged for the quarter.

On-net ARPU in the fourth quarter of 2007 was $1,245.00. In Q1 it was $1,239.00, representing a decline of about 0.5%. Our off-net ARPU continued to increase. Off-net increased ARPU from $884.00 in fourth quarter to $890.00 in Q1 of 2008, an increase of about 0.6%.

Total churn remained consistent at approximately 2% per month. On-net revenue churn is the same that we have experienced for the past two years. Off-net churn remained consistent, approximately 2.5% in the fourth quarter of 2007 and again in first quarter 2008.

We intend to continue to expand our network. During the quarter we added 30 additional buildings to our network. These were both corporate buildings and data centers. We have a total of 1,247 buildings attached to the network as of the end of the quarter. Again to remind you, in 2008 our goal was to add 100 buildings to our network.

We’ve also secured fiber and extended our network into a number of new markets: in Europe, extending the network into the Balkans, into Zagreb in Croatia, Ljubljana in Slovenia. In Italy, our network expanded into Genoa. Here in the United States we’ve extended the network adding Omaha, Nebraska and Indianapolis, Indiana.

During the quarter we also acquired two additional data centers, again consistent with our policy we did not pay anything for these fully constructed centers, but rather took over the operating leases of these centers. This increases our total data center footprint to 36 centers and a total of 340,000 square feet of data center space.

These two new data centers, one was in the Bay area in Oakland, California, the other in Cleveland, Ohio. We will continue to evaluate additional fiber routes and extension in both Europe and North America, but remain consistent in our capital guidance.

Tad would now like to cover some additional details about our operations in first quarter 2008. Tad will also provide our guidance for second quarter 2008 as well as reaffirm and update our guidance for full year 2008. Now I’d like to turn it over to Tad.

Tad Weed

I would like to thank and congratulate our team on their hard work and performance for this quarter. With respect to EBITDA and gross margin, as Dave mentioned, EBITDA as adjusted was $14.6 million for the quarter and that represented an increase of 9.6% from the $13.3 million for the fourth quarter of 2007.

And our EBITDA and EBIDAR margins continue to increase and that’s largely due to gross margin expansion from the increase in our on-net business. EBITDA margin expanded by 140 basis from 26.7% for the fourth quarter to 28.1% for the first quarter. That expansion was consistent with our guidance provided on the last call of 100-200 basis points.

Gross margin percentage again substantially increased and gross margin increased by 270 basis points for the quarter, demonstrating again the operating leverage of the on-net business. Our first quarter gross margin expanded to 57.9% compared to 55.2% for the fourth quarter.

And that expansion also exceeded our guidance for gross margin expansion of 100 to 200 basis points. Gross margin flow through was over 100% with our revenues increasing by $2.1 million and our gross margin dollars increasing by $2.6 million due to the reduction in certain costs.

Loss per share, our loss per basic and diluted common share was $0.21 and that was within our range of $0.17 to $0.22 a share. During the quarter, some of you may notice on the press release we had an asset impairment charge for an unused IRU that had to be fully depreciated during the quarter. That was a $1.6 million non-cash charge or about $0.03 a share and if you exclude that charge, the loss per share would have been $0.17.

We located alternative fiber to serve the related buildings and under the accounting rules you’re actually required to fully amortize the asset, however the corresponding liability since this is a capital lease IRU need to remain until the extinguishment criteria are met and that total liability was $2.9 million at March 31.

Our weighted average shares decreased by about 620,000 from the fourth quarter as a result of shares we bought under our stock buyback program. And we purchased an additional 981,000 shares in the first quarter for $18.1 million. Non-cash equity based comp expense for the first quarter was $5.4 million or about $0.12 per share.

This amount was slightly less than the guidance we provided of $5.5 to $6 million for the quarter. Depreciation and amortization expense was $16.3 million for the quarter and that was within the range of $16 to $16.5 million excluding the impairment charge which is disclosed separately.

Foreign currency impact, the Euro to dollar conversion rate positively impacted our comparable quarterly revenues by about $300,000. For the first quarter of 2008, about 23% of our revenues were based in Europe and about 8% of our revenues were based in Canada. That relationship was consistent with the same relative percentages for the fourth quarter of 2007.

Capital expenditures were $9.8 million for the quarter and $4.3 million for the fourth quarter of 2007. That expected increase is related to seasonality of construction activities. As a reminder, the fourth quarter typically has a moratorium on construction activities so we expect the first quarter to be greater than the fourth quarter.

We continue to expect the total cap ex for the year to be about $30 million. At March 31, 2008, cash and cash equivalents and short-term investments were $155.4 million, this is almost entirely in money market funds. Our capital lease IRU obligations totaled $104.8 million at the quarter end and $7.7 million of the amount is a current liability.

As a reminder, these obligations are paid over a remaining weighted average term of about 13 years. Days sales outstanding on accounts receivable again exceeded our expectations and was 34 days at the end of March. Our bogey for DSO is 40 days so that was substantially better and once again I want to personally thank our worldwide billing and collections team for doing a great job on customer collections.

Cash flow from operations was $11.5 million for the quarter. That was a decline from the $13.5 million for the fourth quarter. That was entirely related to a reduction in working capital and from the lumpiness of some vendor payments primarily in Europe where you have quarterly payments.

In guidance, I’m now going to provide our guidance for the second quarter of 2008 which was included in the press release and update and reaffirm the 2008 guidance. We build our guidance based upon the current expected run rates of our business. Typically for many figures, using the last six-month average, removing any outliers, and this includes our planned increase in sales and marketing programs and our current and anticipated network expansion project.

So for the second quarter of 2008, we expect total revenues to be over $54.5 million. On the components of revenue as compared to the first quarter we expect on-net revenues to increase by over 5% and we also expect off-net revenues to increase by over 5%. We expect non-core revenues to continue to decline and to decline by approximately 15%. As a reminder, we don’t actively market these revenues and they’ll eventually drift to zero.

We expect our gross margin percentage for the quarter to expand by another r100 basis points and we expect EBITDA as adjusted to grow to over $17 million for the quarter. That will be an EBITDA margin expansion of approximately 200 basis points. We expect non-cash based equity comp to be about $4.5 million. We expect depreciation and amortization to be about $16 million and we expect net interest expense to be about $1.5 million.

Those results are expected to result in a loss per share between $0.08 to $0.12. That assumes 46 million weighted average shares outstanding and again if we purchase additional shares the number of shares are reduced on the denominator on the calculation so our loss per share would increase.

For the year, we are refining and updating 2008 guidance provided on the last call. We are reaffirming our total revenue and EBITDA guidance and as a reminder the guidance includes the following: total revenue for 2008 expected to be between $225 and $235 million.

We expect the following annual growth rates from 2007 to 2008: on-net revenue growth of approximately 30%, off-net revenue growth to be between 5-10% and non-core revenues to decline by between 35-40%. We expect the full year 2008 gross margin to increase to approximately 60%. We expect EBITDA to grow to between $75-$80 million.

Depreciation and amortization expense to be between $62 to $63 million, non-cash equity based comp to be between $18 to $19 million, and net interest expense to be approximately $4.5 to $5.5 million.

Primarily from the impact of the impairment charge we took in the first quarter and the impact on our weighted average common shares from our stock purchases and just updating our overall guidance, we are revising the loss per share from, previous was $0.10 to $0.20 per share for the year and we’re now expecting a range between $0.20 to $0.30 per share.

That loss per share assumes approximately 46 million weighted average shares outstanding. Finally as we mentioned on our last call, we do anticipate achieving another corporate milestone in 2008 which is to achieve positive net income by the fourth quarter this year.

I’ll now turn the call back over to Dave.

Dave Schaeffer

As I mentioned earlier, we intend to continue to expand our footprint during the quarter we added 30 buildings to our network. As of March 31 we had 1,247 buildings on-net and in fact we have over 25 buildings in the process o being connected to our network today.

We began the first quarter of 2008 with 192 sales representatives and ended the quarter with 190 sales reps. We again remain very disciplined about maintaining rep productivity. We began the first quarter with 160 full time equivalent sales reps and ended with 156 sales reps.

As mentioned earlier, we are taking a number of proactive steps to increase the retention of reps and to ensure that those reps remain productive and hit their quota goals. As of May 5, this Monday we had 198 sales reps selling our services in both North America and Europe. Those 198 reps equate to 173 full time equivalents under our ramping protocol.

Productivity per full time equivalent rep was 3.6 per FTE less than the four units of productivity we experienced in the most recent two quarters. The efforts that we are undertaking we believe will accelerate that rep productivity. As we continue to grow our footprint, we are also looking to add additional reps to be able to sell into that footprint.

We have a full year goal of adding reps and brining that total to 240 by the end of the year. We feel very comfortable about meeting that goal. We will continue to expand our metro footprint as well as our intercity network. We added over 1,000 miles of metro fiber since the last call and have now approximately 11,000 miles of metro fiber.

We added over 4,000 route miles of intercity fiber and now have over 30,000 miles of intercity fiber. Our network remains one of the most interconnected networks in the world. We are connected to over 2,300 other networks with approximately 330 of these networks being settlement-free peers, the remaining 1,970 networks are Cogent customers.

We believe our network has substantial scale and capacity to support our additional growth. As of the end of the quarter, we are utilizing approximately 21% of the width capacity in our network. In summary, our on-net revenue, our growth business, continues to grow and increase as a percentage of our total revenue and we expect that to continue.

Traffic also continued to grow on our network. We are very comfortable with our 2008 full year and second quarter revenue, EBITDA, sales force and network expansion guidance. Our business remains entirely focused on the internet. We sell no telephony based services. We sell no value-added services.

We believe our product suite and our business model remain isolated from current economic conditions. Our business provides a necessary utility to our customers and this is a utility that continues to grow. We continue to be the industry’s low cost provider. Our simple product set and limited number of SKUs allow us to continue to surpass our 17 day provisioning goal for on-net services.

Again, to remind you, we delivered our services in an average of ten days for on-net services. Our balance sheet remains very strong, especially when compared to others within our sector. We have less than $42 million of true net debt. During 2008, we expect to increase the amount of width IP capacity in our network by approximately 60%.

This will be done within the capital budget that we again reaffirm of $30 million for full year. And finally and maybe most important to our shareholders, under our 2008 plan which we feel highly confident of, we will generate a $1.00 of free cash flow per share for the benefit or our equity holders.

We will continue to consider additional share repurchase programs or other means of returning value to our equity holders. With that, I’d like to now open the floor for questions.

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Jonathan Schildkraut – Jefferies & Co.

Jonathan Schildkraut – Jefferies & Co.

The traffic trends, coming into the first quarter I think you had said on the last quarter call that traffic had increased to January over December by about 6%. What did you see in the rest of the quarter that led to only 7% traffic growth and what were the trends coming into the second quarter?

Secondly if you could go a little bit deeper on the contract length extension. Could you tell us what the average contract length is at this point and also what percent of your customer base is on long-term contracts?

And finally, while you reiterated your $1.00 of free cash flow per share guidance, in the past you’ve also given us an outlook as to what percent that could grow by over the next several years, I’m wondering if there’s any change there?

Dave Schaeffer

You are correct in that in the first month of this quarter as we indicated on the last call, we saw a 6% traffic growth sequentially, month over month. We saw virtually flat traffic for the remaining two months in the quarter.

The internet has experienced this long-term trend of about 70-75% traffic growth and Cogent has consistently outpaced that. Now that growth has generally come from different business models. I would say that the primary driver of traffic growth on Cogent’s network are a number of video models.

Today video is our dominant application. Our largest customer remains YouTube who is primarily a casual video site. We have seen a number of professional video sites being launched but a number of these sites have not gotten the pickup in traffic volume that the casual sides have experienced.

We do believe that the long term trends of traffic growth remain intact but our guidance is really based on the six months trailing rolling average that Tad mentioned earlier and as we look at our future revenue guidance, we feel very comfortable with the approximately 30% growth in on-net revenues for the full year and 5% or greater in the upcoming quarter.

But traffic growth is an important contributor to that and we do believe that we will continue to achieve both gains in market share and the market will continue to grow. Now with regard to contract length, we saw the average contract length continue to expand by approximately 3%. Those contracts remain at about 11.7 months in total and approximately 90% of our customer base is under either a one or two year contract.

And then the final question you had asked was around our continued ability to grow cash flow in the out years. While the company does not have firm guidance, we have said that within about five years we should be producing between $5.00 to $6.00 of free cash flow per share.

And we still feel very comfortable about that outlook and I think investors should feel heartened by both the revenue growth trends that we are exhibiting as well as the phenomenal margin expansion that we demonstrated in the last quarter and as we indicated going forward, we expect that margin expansion both in gross margin and EBITDA margin to continue.

Jonathan Schildkraut – Jefferies & Co.

Coming into then April which is now behind us, was the traffic trend then still flat over March and secondly in terms of the contract length, approximately 90% of your customers are under long term contracts at this point, again that seems to be a fairly large jump, I think last quarter we were about 82.5% and in the past we had thought that 90% was probably about as high as you can get. What’s the company’s feel on that?

Dave Schaeffer

We’re clearly heartened by the fact that people are willing to commit to Cogent and believe in us and will extend our contract. We think we have reached a plateau on contract length at about 90%. But obviously that decision ultimately resides with the customers.

With regard to your traffic growth question, we did see sequential growth in April but it was on the order of 1% and we do anticipate continued growth throughout the quarter but that sequential traffic growth in April over March was bout 1%.

Operator

Your next question comes from Frank Louthan – Raymond James.

Frank Louthan – Raymond James

Where exactly do the sales reps need to be as far as average productivity to hit the revenue growth numbers? And then can you give us an idea, you’ve made quite a few changes to your selling process and the sales force, etc. When do you think that’s going to begin to have some impact? And then with the increase in width capacity I think you said 60%, you said that’s within your budget, can you, A, give us a total cost on that and then what would your utilization be once you’ve gotten that done?

Dave Schaeffer

You are correct in that we have made a number of modifications to our sales force, both in terms of expansion and incentive programs. We believe that we could achieve the goals that we have with the current level of rep productivity that is what projected into our numbers.

We believe, however that the long-term productivity could actually achieve five units per rep which we have done in the past. Our most two recent quarters have been around four units of productivity.

Productivity on a unit basis is a good indicator but not an absolute guarantee of rep productivity because average selling price is also important and the steps that we have taken to incent our reps to continue to stay with us and build a career at Cogent by implementing additional bonuses we think will continue to help us improve not only unit productivity but average selling price.

You saw that in our rate of on-net ARPU decline continuing to decelerate and at some point we’re actually hoping that number goes positive, so people could meet their quota both by selling more units and also by selling at a higher price. We feel very comfortable about our revenue growth trajectory, the guidance that we’ve given and if reps can reaccelerate their productivity we would expect to exceed those goals and we would expect to see continuing improvement throughout this year.

And then with regard to the network capacity, we have a fixed capital budget of approximately $30 million. That budget is basically divided into three major categories: maintenance of the network, new building expansion and finally new route augmentation.

Imbedded in that maintenance number is our need to expand capacity in hot spots in the network and imbedded in that expansion number is the addition of new routes which increases capacity in advance of traffic. As I stated, we expect to see over the course of this year a 60% increase in the amount of IP width capacity.

And the reason why I put that qualifier in there, it’s very important. A large portion of the capital is actually at layer three, not at the optical layer and we continue to expand both the optical layer and the routing layer.

Last year we increased the capacity in our network in excess of 100% and effectively saw our utilization rate go in 2007 from about 14% to 22%. We actually saw utilization rates decline by about 1% in Q1 that was a direct result of capacity expansions as well as the 7% traffic growth.

I would anticipate ending the year with utilization rates of below 30% in our network but that is highly dependent on ultimately traffic growth and we obviously would welcome any acceleration in traffic growth.

Frank Louthan – Raymond James

So what do you anticipate, do you think you’re going to be back up to four units per rep in this quarter and where do you think you’ll end up the year, will it average north of that?

Dave Schaeffer

We believe we will revert back to that trend. Preliminary data for April tells us that we’re doing quite well but there’s still obviously a good bit of time left in this quarter. Initial sales results even in May also say before is probably where we’re going to be. And I would actually hope that we’re at or above four for the full year.

Frank Louthan – Raymond James

Can you tell us, what is your average price per meg for new customers that you’re selling now?

Dave Schaeffer

Our average price is just around $9.00 and that is based on our discount structure that is based on contract term and to refresh people’s memory, it’s $10.00 per megabit month to month, $9.00 on a one-year contract and $8.00 on a two year or longer contract.

Operator

Your next question comes from Tim Horan – Oppenheimer.

Tim Horan – Oppenheimer

On the volume growth, that 7% year over year, what was that in the first quarter of last year or some of the trends? It seems to be trending down. And the reason I mention it is shouldn’t the network centric customer, will revenues from those customers be more correlated really to volume growth? Don’t they add to their capacity as they see their volumes grow?

Dave Schaeffer

You are correct Tim. First of all that 7% number is the sequential quarter over quarter, not Q1 07 over Q1 08, where that number was I think about 65% or 70%. Our full year number was 75% for 2007. So the 7% sequential growth came almost exclusively from our net centric customer base. 96% of all traffic on our network comes from the 58% of our customer base that is net-centric.

And in that market segment we gain revenue two ways, by winning new customers and also by seeing existing customers increase their bandwidth demand. And in fact the rate at which existing customers increase their bandwidth purchases in the quarter was slower in Q1 of this year than it was in Q4 where we grew 14% quarterly sequentially. So our job is to deliver the bits the most effective way possible.

It’s our customer’s business models that will generate that traffic growth. And while we believe the long-term trends remain intact, we look at the deceleration in traffic growth in the quarter and are trying to establish whether or not is an industry wide phenomenon or whether it’s just peculiar to our specific customers.

We think that it was more of a temporal abnormality than any long-term trend. And it is difficult since many of our competitors anecdotally talk about traffic but do not give any clarity in terms of specifics. We are very specific about our traffic growth numbers and our total traffic volume.

Tim Horan – Oppenheimer

On the on-net revenues versus off-net, the on-net sequentially, I know you’re looking for a little bit more than the 5%, but off-net the same thing, it seems like on-net you’d have been thinking more like 7%, 8%, 9% historically and off-net being more flat. Why is that changing do you think and is this a consistent trend you expect going forward?

Dave Schaeffer

It is a trend. We do all of our forecasts based on the past six months of historical data. The reps are now selling both products and one of the things that we get when we basically opened up our sales force in its entirety to both products is we got a pickup in off-net sales.

We hope that we will refocus people on on-net by paying commissions only on gross margin. The on-net product is 100% gross margin, the off-net product is only a 50% gross margin. It is a very large addressable market and reps have found it easier to hit their numbers and fill their funnels quickly with the off-net product.

We actually in our guidance increased our full year expectations for our off-net business as a result of these most recent trends. But we think long term the value proposition of Cogent is the on-net business and we do believe we will revert back to our historical sequential growth rates. But obviously a key component of that was the first question you asked which is aggregate internet traffic growth.

Tad Weed

The previous off-net forecast was flat to an increase of 5% for the year and what we do, we look at the last six months of history for all the components in building the plan, throwing out any lumpiness or outliers. So the amended change to off-net for the year of 08 is an increase of 5-10% and that’s based upon the recent experience that we’ve seen.

Tim Horan – Oppenheimer

Just to play devil’s advocate on the sales force productivity, could it be that you’re just maybe reaching some saturation or this is the optimal number’s around 200 and maybe going to 300 might be counter-productive in terms of productivity and you might drive up your SG&A higher than you would like to see?

Dave Schaeffer

We constantly look at that and do think about it. We actually saw our cost of revenue acquisition continue at our historical run rate. And secondly, when we look at our addressable market, we have a very defined on-net addressable market and today less than half of that addressable market is either a Cogent customer or in the sales funnel.

Our penetration rates remain low. Our corporate on-net penetration is at about 14.6% and our net-centric penetration by unit is at about 7.4%. So we feel that we have substantial head room to add more sales reps and continue to see low cost revenue acquisition and acceleration of rep productivity.

Operator

Your next question comes from Erin Schmitz – Citigroup.

Erin Schmitz – Citigroup

On the unit productivity, I know you’ve talked about it for a little while now but I was wondering if you could identify or just add some color about what actually contributed to the shortfall. Has it been just sales turnover with higher in 1Q or were there other factors that were playing into it that were causing that productivity to be lower in the first quarter?

Dave Schaeffer

I think productivity was lower for a number of reasons. One, the average tenure of the sales force was slightly less than we had seen, so there was greater turnover in the first quarter. Historically that has been the case at Cogent where Q1 has the highest level of sales force turnover. But as I’ve stated earlier, we implemented a number of steps to reduce that turnover in the form of retention bonuses. These are above and beyond quota bonuses and also additional training and additional sales support people.

Secondly, traffic growth was lower than what we had historically seen and therefore we were not getting as many new orders from net-centric customers increasing their bandwidth commitments which will play into sales force productivity. But we feel very comfortable that we can continue to add reps and achieve the productivity levels for the full year that we had indicated, at least four units per rep.

Erin Schmitz – Citigroup

If the traffic growth is lower that’s causing part of this, would that imply if traffic stays at these levels, turnover could be higher in the sales force because they’re not reaching their quotas in the second or third quarters as well?

Dave Schaeffer

For the corporate sales individuals, traffic growth has virtually no correlation to quota achievement since our average corporate customer is only utilizing today about 8% of the bandwidth that they purchase.

And we would not expect to see any correlation there. On the net-centric side, traffic growth is a contributor but we believe that the quotas are obtainable and even with the reduced traffic trends that we saw in the most recent quarter, we would expect to see sales force turnover lower in Q’s two, three and four as we did last year where we also saw a deceleration in traffic growth in those quarters as well.

Operator

Your next question comes from Jurgan Usman – Wachovia Securities.

Jurgan Usman – Wachovia Securities

First of all you said that your guidance is based on historical trend that you’ve seen in the past six or nine months or so and if I take a look at your, on-net revenue guidance, 30% growth, it does imply that you are actually going to increase the run rate to about 8-8.5% of sequential growth in the second half of the year or so. So it seems to be that a lot of this depends on the success of the new retention plan. Can you maybe give a comment on that?

Dave Schaeffer

First of all, our sequential on-net revenue growth for this quarter was 5.7%. If you just kept that rate and compounded it, you are correct we would be below our 30% target at about 28.5%. We are going to be adding additional reps to the sales force as we said we expect to be at the target of 240 by year-end, actually we’ll be there before year end and we’re already adding additional net reps with the main number that we gave as well.

We also believe that reps will be more productive than they were in this quarter which was the lowest that we have seen. So we will see both rep productivity and the number of reps up and we finally believe that the long term traffic growth trends of the internet remain intact and that will help us as well. So we feel very comfortable with our full year sequential revenue, EBITDA, margin targets as well as the sequential year over year revenue target of approximately 30%.

Jurgan Usman – Wachovia Securities

When did you implement this new retention bonus plan and what’s the result so far? Have you seen lower turnover or is it still the same?

Dave Schaeffer

We implemented the plan in the middle of the quarter. We have actually just paid the first round of these retention bonuses. I think it’s too early to say that they’ll be a material impact but we think logically this should help. And we feel pretty comfortable with the growth in the sales funnels of the individual reps. And as I indicated earlier, to Frank’s question, we should see a pickup in unit productivity. We’re already seeing that based on April and early May numbers.

Jurgan Usman – Wachovia Securities

What’s the productivity in terms of dollar sales? I think you’re saying that sales reps are about 72% to 85% or so of the sales people meeting their productivity target, is that still the case?

Dave Schaeffer

No it was lower and that was part of the result of the greater turnover and the rep productivity shortfall. In the quarter that number dipped to approximately 40% of the sales force at or above quota. Now that does not mean 60% of the people are due to be terminated because we allow reps to get to 75% of quote on a three month trailing rolling average.

But it does represent a higher turnover in Q1 than we have historically seen and we do believe based on April’s trend and early May that we’ll see a higher level of rep productivity reverting back to the historical run rate.

Jurgan Usman – Wachovia Securities

Has there been an update in terms of your traffic share of the internet?

Dave Schaeffer

Based on our total traffic volume at year end of about 11 petabits per day and third party data most precisely published by TeleGeography, our market share has increased from about 15% of total bit volume to about 17% of total bit volume carried on the internet. So today we are carrying about 17% of the world’s internet traffic.

Operator

Your next question comes from Nick Netchvlodoff – Lehman Brothers.

Nick Netchvolodoff – Lehman Brothers

The competitive counter offers that you’re making, are they coming more from net-centric customers or your corporate base?

Dave Schaeffer

That one is clear, it’s entirely net-centric. We have not seen any instance, not a single instance of a corporate customer presenting us a bid for a comparable product at a comparable price point that we’ve had to match or beat.

On the net-centric side, we did see an uptick to about a dozen or so situations where customers were better off taking our 50% discount guarantee than our standard price, presenting us with those invoices and I do believe it is an indication of a continued rate of price decline for our competitors while our price remains unchanged.

Nick Netchvolodoff – Lehman Brothers

I know it’s on a very limited basis but is it the same carrying doing it and do you see it as a loss leader for them, are they bundling it with other offerings, what’s the motivation behind the more aggressive price posture?

Dave Schaeffer

It is predominately one carrier, although there are several carriers that we have responded to but the majority came from one carrier. That carrier I believe referred to these products as their debased product set or low value product set which quite honestly as someone who’s focused on the internet, I take a bit of offense at.

I think the internet provides the greatest amount of value to consumers. We have not, however, seen that product combined with any other products. I think particularly for our net-centric customer base, they buy products based on the value of each product. Our net-centric customers for example do not tie their corporate telephony needs or other product needs to their net-centric purchases.

Nick Netchvolodoff – Lehman Brothers

About the sales reps just briefly, what you’re saying is your more tenured reps are the ones that are leaving and are they going anyplace in particular? What’s their next career move? I know everyone has a different story but what’s motivating people to leave?

Dave Schaeffer

It’s actually not the most tenured reps who are leaving, those seem to be here, it seems to be people, we’ve got reps that are initially hired that turnover very quickly because of the activity based nature of our sales process. That the retention bonus isn’t going to really address.

But it’s really those reps that have been here six to 12 months are producing, are hitting their quotas but perhaps feel a bit stressed by the continued activity level because as we do our analysis of our rep productivity, we see almost a perfect correlation between high activity level and quota attainment.

So what we are really focusing on are those reps that have been here six to 18 months and giving them these incremental six month bonuses after they make it six months, have achieved 75% of quota or better on a rolling three month trailing average, they get a bonus, in addition to their commission and then additional bonuses at months 12 and 18. And this is really incentive to keep those reps here for at least a couple of years.

Operator

Your next question comes from Tom Watts – Cowen and Company.

Tom Watts – Cowen and Company

The on-net traffic patterns, if we break it apart between, or I’m sorry on that revenue growth, if we break that out between net-centric and corporate customers, was the slowdown, it sounded like the slowdown was more on the net-centric side, did I understand that correctly or are you seeing a slowdown on both sides?

Dave Schaeffer

Our corporate customer base represents only 4% of our traffic even though they represent 42% of revenue. We continue to see historical growth rates there of better than 100% but because it is such a small portion of the total base of traffic, it’s not material and more importantly for the corporate customers there is virtually no correlation between traffic growth and revenue growth in that the average corporate customer is only using about 8 megs of their 100 met connection.

What it does do is make those customers more likely to stay with Cogent even if they look to move out of a building, they’ll look to get into another building that Cogent has led. And we consistently see that pattern among our corporate customers. Now on the net-centric side, that’s where we saw the rate of traffic growth decelerate from 14% last quarter to 7%.

And there is a much closer correlation between revenue growth from existing customers and existing customer traffic growth. Now our traffic growth number represents both new customers and growth from existing customers, but what we saw in the quarter was our existing net-centric customer base not experiencing their historical rate of traffic growth and that then results in both lower sales force productivity and lower sequential on-net revenue growth at 5.7% quarter over quarter.

Tom Watts – Cowen and Company

So if we look to revenue growth from the corporate base, has that rate changed at all from Q4 to Q1?

Dave Schaeffer

No, virtually not at all.

Tad Weed

The mix both based upon revenue and connections was virtually identical from the fourth quarter to the first quarter.

Operator

Your next question comes from Andrew Bill – [Arete] Research.

Andrew Bill – [Arete] Research

Your sales force, as you’ve ramped it to increasingly high levels, you’ve increasingly run into churn issues. And from what I can make out that seems to be one of the major factors behind the sales force productivity.

But look at how you sold this and I hate to talk about people in this way, but how could you industrialize the recruitment process a bit more to give you a greater number of gross hires, how can you weed out the poorer performers a bit earlier and how can your retain the best? I’m just thinking about that as a major driver of your revenue growth alongside traffic.

Dave Schaeffer

We are very focused on growing our sales force in particular because we are looking at an addressable market where less than half of the market today has been contacted. So sales continues to be a bottleneck. We have put additional resources into our recruiting effort, we’ve actually gone in the past year from one to three recruiters.

We are spending a lot more time on the front end in terms of both interview process, reference checks and once we hire someone, training and supporting those individuals. Those are all positive things that we can do. It does sound a bit harsh but we do manage out underperformers pretty quickly. We’ve actually been criticized in some part for being too extreme in managing out those people too quickly.

Most of our competitors generally have ramp schedules of six to 12 months until reps become fully productive. We actually stick with a four-month ramp schedule. We’ve actually done analysis looking at existing reps and said if we in fact lengthen that ramp cycle, would we materially improve retention and the answer is yes, we’d improve retention but the reality is at a lower level.

It’s not like with an extra month or two a rep who wasn’t making it would make it. I wish there was a single magic bullet that we could shoot and improve our rep productivity and industrialize it as you said, but the reality is, it is a telesales organization and what you need to do is be vigilant on monitoring rep activity levels and continuing to incent them correctly.

And I think we’re doing all of the right things. Ultimately that traffic growth does play into it and if traffic growth accelerates, rep productivity goes up for the net-centric reps in direct relationship to that.

Andrew Bill – [Arete] Research

Do you think you just need to add to the rate of gross hires given that your sales force churn is running in the high single digits? Do you just need to have more gross hires?

Dave Schaeffer

The answer is yes. We will continue to hire at an accelerating pace. We also feel comfortable that the rate of churn decelerates for the past three years and will this year as well in Q’s two, three and four. We feel very comfortable about our yearend target. Just to remind you, last year we actually in the third quarter increased our yearend target and beat that target in terms of number of reps.

I’m not guaranteeing that we’ll do that this year but we feel very comfortable about the target we’ve laid out. We’ve got enough recruiting resources in hand and we believe that the revenue guidance and growth numbers that we’ve laid out are achievable with our sales force.

Operator

Your final question comes from David Dixon – Friedman, Billings, Ramsey.

David Dixon – Friedman, Billings, Ramsey

I wanted to spend some time dimensioning the competitive trends that we’re seeing in net-centric and enterprise segments, specifically in the net-centric segment, could you help us with the difference in the level of competition that you’re seeing, focusing in on the oversubscription model perhaps and relative to the better network quality service that you’re providing.

I’d be interested in just exploring that with you and then a question just in terms of productivity. Could you help us with the level of base comp relative to the industry and whether that is one area where you could or have made some changes under these new incentives.

Dave Schaeffer

We remain the price leader in the market. We have a standard offer that says we will undercut any of our competitors if they show us an invoice for a comparable product. Now our product is non-oversubscribed and non-[bok]. Most of the other major backbone operators offer a similar product, particularly to net-centric customer who tend to utilize most of what they purchase.

We do sell to a large number of companies that resell our services and dramatically oversubscribe their resale. So examples would be some of our major cable customers. We have one of the largest cable companies in the world, maybe the largest, as a customer.

They buy from us typically at $9.00 a megabit and then sell to their end users actually a product at $2.00 a megabit but based on the fact that they oversubscribed that connection, generally about 300:1. Now they’re providing the local access component to it in conjunction with that oversubscription.

We also see that model from a number of smaller resellers in the net-centric market that tend to focus on the very small customer segment. Gut for any customer in the net-centric market, they generally need the bandwidth they are purchasing and are not comfortable with either oversubscription resulting in degraded service or bit transfer caps.

Most recently in the news, you’ve seen a lot of discussion around some of the major access networks putting total bit volume caps on customers where they then charge a premium if a customer uses more than their allotted bit volume even though that may not utilize all of their megabit transfer rate based on their guaranteed line rate and the number of minutes in a month.

To your second question around base comp, our typical comp packages are 50% base and 50% at quota. So our reps are divided into three major tiers. Our entry level or ram one reps generally have comp packages of about $80,000, $40,000 of base, $40,000 of variable. Mid tier reps are at about $95,000, $47,500 and $47,500. And our senior reps or ram threes are at about $140,000 with a 50% base 50% variable.

Now reps can substantially exceed this if they in fact sell more than 100% of quota. The top reps here routinely make hundreds of thousands of dollars a year above their target for those that over perform. Now the implementation of the retention bonus is a desire to increase the base component for reps and keep them here for a longer period of time.

That is really targeted on the ram one so the idea would be a ram one who’s got six months of tenure would go from a $40,000 to $45,000 base and then with 12 months of tenure would go to a $50,000 base and then 18 months would go to $55,000. We think that additional base compensation without impacting the variable component will incent people to stay in a telemarketing environment longer.

Operator

There are no further questions at this time.

Dave Schaeffer

Well again a relatively lengthy call but we thank everyone for their interest, we thank the team and management will be available for any follow on questions. Again thank you all very, very much. Take care.

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Source: Cogent Communications Group, Inc. Q1 2008 Earnings Call Transcript
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